CREFC PRINCIPLES BASED UNDERWRITING FRAMEWORK December 2010

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1 I. Introduction Commercial mortgages provide the capital and liquidity for real estate owners to build and operate the properties in which we live, work, and shop; the properties that house the businesses, large and small, that fuel our nation s economy. These loans are primarily made by banks and insurance companies, either to be held in portfolio or packaged and sold as commercial mortgage backed securities (CMBS). In all cases the lenders, through their underwriters, assess the risks of the loans by analyzing the operations of the properties being financed. The properties have revenues primarily rent collected from tenants and expenses the costs of maintaining the properties that generate the net cash flow required to service the contractual monthly principal and interest payments of the proposed loans. This business aspect of commercial mortgage finance distinguishes it from single family home lending, where the mortgage payments are funded through the earnings of the borrower, unrelated to the real estate collateral securing the loans. Section 941 of the Dodd Frank Wall Street Reform and Consumer Protection Act enacted earlier this year directs the implementing federal banking agency regulators to among other things craft underwriting standards that specify the terms, conditions, and characteristics of a loan within the asset class that indicate a low credit risk with respect to that loan. This paper encapsulates CREFC s views and suggestions on such standards and it therefore focuses on loans originated for CMBS, which are primarily collateralized by first mortgages on stable, cash flowing real estate including multifamily, office, retail, industrial, and hotel properties. Underwriting the financing of the acquisition and development of multifamily or commercial land, construction loans, or mezzanine financings typically originated by banks for their portfolios will not be addressed herein. All loans have risk of default, and the underwriting process is designed to identify and enable lenders to mitigate those risks. A thorough underwriting process applies consistent standards across similar categories of properties and markets. As a general matter, however, the members of CREFC repeatedly have concluded that the heterogeneity of the loans securitized through CMBS do not lend themselves to the development or application of any objective underwriting standards that would indicate a lower credit risk with respect to such loans. All commercial properties are unique due to their competitive positions within their markets and in the quality of their physical plants, tenancy and management, and the risk analyses must therefore be property specific. 1

2 Accordingly, this paper outlines a framework of underwriting principles and procedures that we believe results in generating lower credit risk loans, but the uniqueness of each property requires lenders to appropriately customize their underwriting to reflect the facts and circumstances of each proposed loan. An underwriter s adherence to this framework and a disclosure regime that emphasizes the manner in which the underwriter has done so would help both to increase the integrity of the underwriting process and to enable investors to independently evaluate the decisions made during the underwriting process so that they can formulate their own conclusions regarding those decisions. Generally, commercial mortgages with the following attributes have a lower risk of default: The value of the collateral is substantially higher than the loan amount to provide cushion in times of falling property values; The borrower or sponsor has significant cash equity in the property and is incentivized to keep the loan current through its term and repay the loan at maturity; The property is well managed by an experienced property manager; The property is located in a desirable market that attracts high quality tenants, and the property can effectively compete for those tenants through its location, quality of its space, and amenities; The property is fully leased by credit worthy tenants with leases that extend beyond the maturity of the proposed loan; The property generates cash flow from its operations that exceeds the periodic interest and principal payments of the proposed loan (the debt service ) by a sufficient margin to protect the lender from fluctuations in that cash flow due to unexpected economic and market events; and The loan is structured such that, depending on leverage, it either fully amortizes or has some level of amortization over its term, has reserves for re leasing and capital expenditures, and employs other forms of credit enhancements appropriate to mitigate certain risks. Not every property is a trophy asset in a top tier market, and therefore not all commercial mortgages will reflect all the attributes of a low risk loan. There is inherent risk in commercial mortgage lending. The goal of CMBS is to provide liquidity not just to trophy properties, but to all markets and properties while appropriately identifying and mitigating those risks. Therefore, it is critically important that lenders conduct a thorough underwriting process that identifies the risks of a proposed loan, sizes and structures the loan in consideration of those risks, and clearly discloses the risks and structural enhancements to investors. Such transparency will enable investors to understand and price the risk of commercial mortgage pools and regain confidence in securitization vehicles. 2

3 The ultimate test of an underwriter s conclusions and recommendations is the actual performance of a loan throughout its term and at maturity. An underwriter is challenged with determining a borrower s capacity to make timely payments of debt service and the ultimate repayment of principal at the maturity date. Accordingly, in underwriting commercial mortgages an underwriter considers the various types of defaults in making the credit decision: a. Term Default The risk of default during the term of a loan, from loan origination through loan maturity, is deemed the Term Risk of the loan. Several key parameters are utilized in measuring Term Risk with the most common metric being debt service coverage ratio (described more fully in Section III below). If property cash flows were evenly distributed over the loan term without volatility, assessing Term Risk would be simple. However, over time property cash flows often prove to be uneven due to lease turnover and variability of expenses. An underwriter therefore considers the impact of potential disruptions to the revenue stream, and requires a higher debt service coverage ratio and other structural credit enhancements, such as reserve funds, that will enable a loan to remain current during its term. b. Maturity Default The risk of default at the date when a loan is due is referred to as the Maturity Risk of the loan. Maturity Risk reflects the ability of a borrower to either obtain refinance proceeds sufficient to fully repay the matured loan or to sell the property and utilize sales proceeds to repay the loan. Common credit metrics used to assess Maturity Risk are debt constants, debt yield and loan to value ratio. An underwriter considers the relationship between lease termination and loan maturity to assess how a new lender will view the quality of the property s cash flow if the loan is to be refinanced at maturity. During periods when the availability of credit is scarce, interest rates are trending upward, and/or property values have fallen, there is risk that a loan can meet its debt service obligations up to maturity, but cannot meet its repayment obligation. An underwriter can mitigate such risk by lowering initial loan proceeds or requiring amortization of the loan during its term. c. Technical Default While term and maturity defaults are known as Monetary Defaults, defaults of a non monetary nature are referred to as Technical Defaults. The term Technical Default should not be interpreted as a minor default because some technical defaults can result in severe losses to the lender if not cured by the borrower within a reasonable period of time. For example, if a borrower neglects to adequately insure a property, as required by the terms of the mortgage, the property and loan may be exposed to material adverse consequences and risk of 3

4 loss. In determining the likelihood of a technical default, an underwriter evaluates the borrower s willingness and capacity to comply with the requirements of the loan agreements beyond payment terms. Thorough underwriting designed to avoid default risk focuses on four key areas: The economic strength and supply and demand dynamics for other properties in the market in which the collateral property operates; The competitiveness of the collateral property in its market and its ability to generate cash flow to pay debt service during the term of the loan and be refinanced upon maturity; The equity contribution and management expertise of the borrower/sponsor; and The structure of the proposed loan to minimize and mitigate known risks. To promote high quality underwriting with greater transparency, CREFC is offering the following principles based underwriting framework relating to each of these analyses, as well as common definitions and computations for the key metrics used by lenders. II. Market analysis The dynamics of the market in which the property operates provides the foundation for the likely performance of the collateral. A comprehensive market analysis includes an assessment of macro and local economic and demographic trends, supply and demand factors impacting the property, and the positioning of the property relative to competitors. By tracking and projecting market trends, an underwriter can reasonably predict the commercial viability of a particular property over the long term including the term of the loan and beyond the anticipated refinance period. A thorough understanding of overall market conditions allows an underwriter to more accurately assess underwritten cash flow and projected performance, and form a current and future value opinion for the property. a. Economic and demographic trends Over the life of a loan, commercial real estate fundamentals (e.g., rents, vacancies and absorption) are correlated to broad trends of the economic cycle, including GDP growth, employment growth, business investment, disposable income and consumer sentiment, and changing market demographics. Both economic and demographic trends influence the demand for space. On a local level, market specific economic conditions can have a profound impact on local commercial real estate fundamentals. Local market conditions tend to be sensitive to factors such as trends in population growth, major area employers, local job formation, household formation, median income and disposable income. Hence, risk is reduced when the 4

5 property operates in a robust market that generates space demand through increasing employment and other local attributes. b. Supply and demand Supply in a given market or submarket is determined by the current inventory of a particular property type or, more granularly, by a subtype of property within a given property type, plus new and planned development. Future supply can be assessed by reviewing local zoning and building codes as well as planned developments in the permitting or local building approval process. Population, economic diversity and growth drive demand for space for each type of property in the market. Market rents, vacancy rates, lease up times, leasing concessions and tenant improvement allowances are the quantifiable impact of supply and demand dynamics on property performance (that is, cash flow). Sales prices, capitalization rates and discount rates are the quantifiable results of supply and demand on property valuation. Risk is reduced in markets where demand meets or exceeds current and anticipated future supply. c. Competitive set Ultimately an underwriter assesses whether tenants want to be in the particular property collateralizing a proposed loan. Accordingly, beyond understanding the supply and demand trends in a particular market, an underwriter also assesses a property s strengths and weaknesses relative to its competition. Comparative factors include location, size, property condition and age, parking ratios, ingress/egress, amenities, views, visual appeal and a host of other factors both quantifiable and non quantifiable. The underwriting process must consider future changes to the competitive set, such as additions to supply or renovation and upgrades to a competitive property, which will likely impact the subject property s desirability and performance in terms of absorption, vacancy, and rental rates and concessions. III. Property Cash Flow Analysis a. Overview A collateral property s current cash flow is the primary indicator as to whether a proposed loan s periodic debt service will be paid, and a property with stable and increasing cash flow will maintain the value required for repayment at maturity. Accordingly, detailed analysis of all property revenue and expenses is essential to underwriting and risk mitigation. Most loans that are securitized (particularly fixed rate loans) are collateralized by stable properties; that is, properties that are fully or nearly fully leased to their market potential and have one or more years of operating history. As a result, an underwriter focuses on the property s current cash flow characteristics. 5

6 For an income producing property, Net Operating Income is defined as total revenue less total expenses; it is the income generated by the property from its usual operations, excluding expenditures likely to be capitalized rather than expensed by the borrower. Revenues generally include rental income from leases (or nightly room rates for hospitality property), contractual reimbursement of operating expenses, participation in tenant sales revenues (for certain retail properties) and other recurring revenue related to a property s operations. Expenses encompass costs associated with operating and maintaining the property, including management fees, franchise fees, utilities, routine maintenance, cleaning and landscaping, employee salaries, marketing, costs of goods sold (for hospitality property), insurance and real estate taxes. Net Cash Flow is defined as Net Operating Income less the cost of capital improvements necessary to maintain the property in its current condition and, in the case of commercial property, the cost of re tenanting space upon lease expiration, which may include both leasing commissions and tenant improvements. In order to accurately analyze property cash flow, the underwriter obtains, at a minimum, the following information from the borrower: Operating statements prior three calendar years (if available) and most recent yearto date; Operating budget current and future year operating budget; and Current Rent Roll should include the tenant name, leased area, lease commencement date, lease expiration date, current rent, contractual rent increases during the lease term, operating expense reimbursements, renewal options, termination options, current or future concessions, and other pertinent terms or conditions such as cotenancy provisions. Co tenancy provisions are most often found in retail leases wherein the loss of a major tenant or combination of tenants creates additional rights to one or more remaining tenants. These rights most frequently take the form of reduced rental payments, rental payments calculated as a percentage of gross sales, or other concessions that would adversely impact the property cash flow. Such rights continue until new tenants are procured by the landlord/borrower and open for business. The landlord s inability to re tenant the property within a specified time frame may give other tenants additional rights, up to and including early lease termination. The above information should be certified by the borrower or sponsor who would be legally or financially liable to the lender for the accuracy of the information. Certain summary information from the historical and recent operating statements and rent rolls are generally disclosed to CMBS investors in the offering documentation. In addition, CREFC s Model Representations and Warranties include a representation from the Loan Seller that it has 6

7 obtained historical rent rolls and operating statements for each property, and the Mortgage Loan Documents require the borrowers to provide such information on an ongoing basis. To further understand and verify the property cash flow, an underwriter obtains and reviews additional supporting information, which may include but is not limited to: Tenant leases; Management agreement; Utility invoices; Property tax invoices; Insurance policies; Service contracts; Equipment leases; Ground leases; Historical occupancy schedule; Borrower bank statements or collection reports; Historical capital expenses and leasing costs; and Reciprocal easement agreements, condominium agreements, PUD agreements and other documentation affecting property operations. b. Historical Net Operating Income To understand a property s cash generation ability, an underwriter first reviews net operating income during prior periods. Typically, the source for historical net operating income is financial statements prepared in accordance with generally accepted accounting principles (GAAP), which may or may not have been audited by a certified public accountant. The underwriter computes a Historical Net Operating Income, which is the actual net operating income the property has generated in previous years, excluding non recurring or extraordinary items or non property related items. For example, if a prior year s operating statement included significant investment income that was attributable to a borrower s investments rather than the property s operations, such income would be eliminated from revenue in computing Historical Net Operating Income. Historical net operating income may be based on one or more prior 12 month periods, or from a partial year that has been annualized, if such annualization can be supported. In general, a property with one or more years of history of net operating income, especially if substantiated by audited financial statements, is considered less risky than a property with revenue and expenses that have not yet been fully determined or stabilized. To the extent available, historical operating information for the past three years is generally disclosed in CMBS offering documentation. CREFC recommends the following fields 7

8 be included in Annex A for the past three years: Effective Gross Income, Operating Expenses, Net Operating Income, Capital Expenses, Net Cash Flow and Occupancy Percentage. c. Underwritten Net Operating Income A critical component of arriving at a sustainable property cash flow is the underwriter s determination of a property s Underwritten Net Operating Income, also referred to as Normalized Net Operating Income. The Underwritten Net Operating Income is meant to reflect the stable and consistent net operating income of the property, eliminating any periodic anomalies. For example, if fuel costs were particularly high in the current year, an underwriter might average the fuel costs over the prior three years to derive a more appropriate indicator of normal performance. Accordingly, an underwriter considers trends in property income and expenses and how these trends may be impacted by current and anticipated market conditions. Underwritten Net Operating Income is derived based on facts regarding the market and the property rather than speculative projections regarding the property s potential performance. In CMBS lending, significant assumptions are documented and disclosed to investors. The Underwritten Net Operating Income is generally based on a current rent roll and Historical Net Operating Income with certain adjustments made to revenue and expenses to reflect known facts and circumstances regarding the property s current operations and market conditions which may include: Contractual increases in rent over the next six months for leases in place; Newly executed leases that may not have been in place during the previous period; Leases that have expired during the previous period; Leases that will expire in the next 12 months; Contractual increases/decreases in operating expenses; Real estate tax increases/decreases based on changes in assessed value or millage rate; and Any new revenue or expense items calculated based on adjustments to other revenues and/or expenses. The calculation of Underwritten Net Operating Income involves a detailed look at each property related revenue and expense item as described below. The following fields are recommended by CREFC to be included in Annex A to provide investors more detailed information regarding the underwriting assumptions: Revenues, Effective Gross Income, Operating Expenses, Replacement Reserves, Net Operating Income, Capital Expenses, Net Cash Flow and Occupancy Percentage. 8

9 Rental Income An underwriter analyzes each line of the property s operating statement provided by the borrower. Perhaps the most important part of the analysis is assessing the sustainability of the property s rental revenue, which typically begins with an understanding of in place rent, that is, the rent that the borrower is currently collecting from the property s tenants based on lease obligations, without underwriting adjustments. As an underwriter assesses revenue more fully, the details of the analysis vary by property type. For multi family properties, the analysis focuses on market trends and whether the collateral is achieving rents and occupancy levels consistent with market averages. Location, access, parking, proximity to employment and retail centers, services and amenities are all considered in assessing the property s ability to generate ongoing demand for tenants. For hotels, an underwriter focuses on the various components of revenue rooms, and food and beverages as well as the property s mix of business/leisure customers, flag (branding) and reservation system, and the management experience of the operator. An analysis of senior housing reflects the level of care provided to the tenants, which ranges from meals to full medical staffs, and whether the revenue is private pay or based on reimbursements from Medicare and Medicaid. For an office, retail or industrial property, the analysis focuses more on the terms of individual leases and the creditworthiness of the tenants. Leases are reviewed to understand base rent, concessions granted to the tenants as inducement to rent, reimbursements of the property s operating expenses, and the terms of the leases and tenants options to renew. On a property level, the percentage of space with expiring leases in each year the rollover analysis identifies potential disruption to cash flow during the term of the loan. The in place rental rates are compared to the rental rates achieved at comparable properties in the market to determine if the building is competitive and if rental revenues may rise as leases expire (although such higher rents would generally be excluded from Underwritten Net Operating Income unless the new lease contracts have already been executed). An underwriter also assesses whether the in place rental rates exceed the rental rates achieved at comparable properties in the market. Such a rental rate premium may result in the underwriter reducing the rental revenue when computing the Underwritten Net Operating Income if the underwriter is concerned that the premium is not sustainable. If a property is not fully leased, an underwriter will typically withhold credit for future leasing, except in some instances in which a tenant has executed a lease but has yet to occupy its space. Other anticipated improvements in property performance are usually not factored into the underwritten cash flow. However, anticipated deterioration in rental income or 9

10 negative events (e.g., excessive lease rollover during the loan term in a property with above market leases, or deteriorating market conditions) are addressed by employing more conservative underwriting assumptions and/or through the utilization of structural enhancements such as reserves or letters of credit discussed in Section V. Repayment risk is mitigated by the creditworthiness of the tenants in combination with the lease terms, both key drivers of cash flow stability. Leases are contracts that typically cannot be terminated unless the tenant is in bankruptcy. Hence, having high credit quality tenants on long term leases significantly enhances the stability of the property s revenue over the term of the loan. In contrast, weak or insolvent tenants may not be able to meet their obligations and could trigger a lease default. Retail properties may further have co tenancy clauses where the performance of one weak tenant affects the lease terms of another (potentially healthier) tenant. Typical adjustments that may be made to Historical or In Place rental revenue include: Rent in place with contractual rent increases over the next six months; Rent in place with index related rent increases over the next six months; Rent for leases signed but tenants not yet in occupancy; Rent for dark/bankrupt tenants excluded; Mark to market based on prevailing market rents (including concessions); Mark to market based on occupancy costs (retail properties); Rent decreases due to co tenancy provisions; and Adjustments for non recurring concessions. An underwriter s mark to market adjustments to rents and occupancy costs usually result in cash flow decreases and are only used to increase cash flow when facts and circumstances clearly support that conclusion. Borrowers may execute leases for rental space in their own properties in order to increase contractual revenues and improve Net Operating Income. These intercompany leases, sometimes referred to as master or umbrella leases, provide for payments of rental income from one property owner controlled entity to another, regardless of whether or not the space is occupied. Future tenants may execute subleases with the master tenant, with any positive or negative difference in rental payments retained by the master tenant. Since master leases are not arm s length contracts, they may not reflect prevailing market terms, and could artificially inflate the Net Operating Income of a property. In a distressed situation, a borrower may withhold rental payments on a master lease. The revenue from master leases are not included in an underwriter s calculation of rental income unless the following are true: (a) the lease reflects market terms, (b) the master lease premises are either improved and ready for 10

11 occupancy or have reserves set aside for tenant improvements, and (c) the master tenant is considered investment grade creditworthy, or has posted reserves to make rental payments. The methodology used for determining underwritten rental income should be described in detail and disclosed to investors. The offering documentation contains information regarding the amount of revenue used in the underwriting of the loan and any revenue from master leases or ground leases will be separately noted. Occupancy Even if the property appears to be stabilized, an underwriter confirms occupancy because only occupied space generates revenue. Seemingly straight forward, the occupancy rate may be computed in several ways, and impacts the likely cash flow to be generated and the risk of the proposed loan: Physical Occupancy: The amount of space on a square footage or unit (multifamily, hotel) basis that is currently occupied by a tenant divided by the total square footage or total units available for lease. This calculation represents the total space at the property that is occupied by a tenant on a percentage basis. In commercial properties, a tenant must be open for business and paying rent to be considered as an occupied tenant. Economic Occupancy: The total rent collected from the property divided by the total rent the property would achieve if it were 100% occupied. This calculation represents the total rent on a percentage basis that the property is achieving. If economic occupancy is less than physical occupancy, it could signal that the property is experiencing collection issues or achieving rents that are less than market rates. Conversely, if economic occupancy is greater than physical occupancy, the property may be benefitting from above market rents, which could negatively impact cash flow as leases expire and replacement lease contracts at lower rents are executed. Leased Occupancy: The amount of space on a square footage or unit basis that is currently leased divided by the total square footage or total units. To be considered a leased space, a signed lease must be executed; however, the tenant does not need to be physically in its space to be considered a leased tenant. Leased occupancy is used to determine how much space is remaining to be leased. In CMBS lending, the methodology for computing occupancy should be documented and disclosed to investors. Annex A in the offering documentation should address current physical occupancy. Historical occupancy information should be provided by the borrower and disclosed in Annex A. 11

12 Percentage Rent/Overages Certain retail property leases provide for the collection of a percentage of the tenant s sales ( percentage rent or overages ) in addition to or in lieu of base rent. Percentage rents are inherently more volatile than contractual base rents due to the variability of consumer demand for the tenant s merchandise. Accordingly, an underwriter will typically evaluate percentage rent on a tenant by tenant basis. Depending on the historical stability and trend of percentage rent collected by the borrower, and current market rental rates relative to the rent the tenant is paying (including base rent, percentage rent and reimbursements), an underwriter determines an appropriate amount of percentage rent to underwrite. Often the percentage rent is underwritten at a discount or excluded altogether from the underwriting analysis due to its volatility. Acceptable methodologies for calculating underwritten percentage rent include: Current year to date or trailing twelve month sales results; Previous year collections; Previous year collections plus adjustments (inflation/changes in tenancy); Previous year sales; Previous year sales plus adjustments (decreases in sales/inflation/changes in tenancy). Expense Reimbursements Many commercial leases, particularly for office, retail and industrial properties, require tenants to pay a portion of property operating expenses, which may include items such as utilities, repairs and maintenance, real estate taxes, insurance and in some cases management fees. The calculation of underwritten expense reimbursements can be complicated and may be presented in a number of different ways, including: Previous year collections; Previous year collections with adjustments (inflation/changes in tenancy); Individual lease terms and previous year operating expenses; and Individual lease terms and pro forma operating expenses. Leases may specify certain percentage allocations for operating expense reimbursements, or may simply be based on a pro rata allocation. Often, tenants may only be required to pay for increases in expenses over those expenses incurred in a specific previous year (base year) or those expenses above a fixed amount. 12

13 Specific calculations of expense reimbursements, based on actual lease terms and supportable operating expenses (discussed below) are usually superior to simple estimates based on prior year actual expenses. Effective Gross Income To estimate total property revenue, an underwriter may also include other income from such sources as parking, laundry and other services, depending upon the type of and circumstances at the property. Other income is typically based on consistent historical collections over several periods, and may be adjusted to reflect actual or anticipated changes in occupancy or use of the property. An underwriter often computes the gross potential rent of the property, that is, the maximum rental revenue that could be achieved if all the space were rented at market rates, and then deducts vacancy, below market rents, credit loss, and rental concessions to derive Effective Gross Income. Effective Gross Income underwritten for the loan is recommended to be included in Annex A. Operating Expenses An underwriter also reviews trends in the operating expenses of the property. Such expenses include employee salaries, utilities, maintenance and repairs, marketing, insurance and real estate taxes. Hotels and senior housing have unique expense categories mirroring their revenue components. Fluctuations in certain expenses during previous periods are either normalized to determine the average monthly expenses or analyzed to determine how changes in occupancy over time impact the variable component of the expenses. In addition, underwritten operating expenses may reflect inflation adjustments, new operating contracts with service providers, changes in occupancy, changes in employee salaries, changes in utility rates, and efficiencies related to capital improvements. Underwritten operating expenses may be determined using alternative methodologies including: Previous 12 months; Previous 12 months with adjustments (inflation or changes in occupancy, etc.); and Forward budget. Aggregate Underwritten Operating Expenses are recommended to be included in Annex A. 13

14 Management Fees Another expense is the fee paid to the property manager. When the property is ownermanaged without a management agreement or when the property s management company is an affiliate of the borrower, management fees are typically underwritten at market levels for that property type. Generally, an underwriter assumes a minimum management fee, which can range from 3 5% of Effective Gross Income. For very large properties, the gross amount of underwritten management fees may be capped at a specific dollar amount. Underwritten management fees may be determined using various methodologies including: Percentage of Effective Gross Income; Percentage of Effective Gross Income excluding certain line items (types of expenses); Cap at a maximum dollar amount per annum; and Actual management agreement. Real Estate Taxes Real estate taxes are underwritten to current levels when it is determined that these taxes reflect a full assessment of the property. If the property is not fully assessed or is benefitting from a tax abatement, underwritten taxes should be increased to reflect the market value and property tax rates within that jurisdiction unless the abatement is for an extended period of time past the loan maturity date, in which case taxes below full assessment can be used. If the assessment is being appealed by the borrower, the underwriter only uses the lower assessed value if the appeal has been successfully concluded. When the loan is financing a property acquisition, an underwriter also considers whether the sale will trigger a reassessment based on the sales price. Similarly, the underwriter may consider an increase in real estate taxes that may be triggered by a foreclosure or other property transfer related to the financing. Underwritten real estate taxes may be determined using alternative methodologies including: Previous 12 months; Previous 12 months with adjustments (inflation); Including/excluding tax abatements; Current tax bills; and Pro forma assessment and millage rate. Insurance During the past few years, there has been additional focus on insurance coverage, particularly the types of events and conditions that are covered by the policy/ies, and the related costs of the various policy/ies (see additional information relating to insurance in 14

15 Section V). In addition to standard coverage for hazards, liability and business interruption, coverage for terrorism is often required for collateral securing CMBS loans. Additionally, if the collateral is in a seismic or flood zone, or a region with a history of windstorms, an underwriter will typically require insurance covering damage from such events. An underwriter is also increasingly focused on the management of mold, termites, and other circumstances that may deteriorate the property s condition. Underwritten insurance expense may be determined using various methodologies including: Previous year; Previous year with adjustments (inflation); and Revised insurance quote. The CREFC Model Representations and Warranties contain representations from the Loan Seller with respect to the insurance in place on the Mortgaged Property, including hazard, liability, business interruption, terrorism, flood and seismic (as appropriate). Ground Rent A mortgage loan may be secured by a borrower s fee interest in the land and improvements, or a leasehold interest whereby the improvements are owned by the borrower, but use of the land is pursuant to a ground lease between the borrower, as ground lessee, and the land owner, as ground lessor. In a typical ground lease, the ground lessee has full use of the property during the term of the lease, after which the right to use the land reverts back to the ground lessor. Since improvements on the leased land (including buildings, fixtures, paving and landscaping) cannot be removed, the use and ownership of the improvements will also revert to the ground lessor at the end of the ground lease term. Therefore, it is important to confirm that any mortgage debt secured by a leasehold property will be fully repaid prior to the final maturity of the ground lease. Mortgages secured by properties subject to ground leases are considered riskier than those secured by fee simple interests because there is a third party entity with a financial stake in the real estate; the building owner has additional performance thresholds as detailed in the ground lease. Therefore, important considerations in underwriting a property subject to a ground lease include the following: Term An underwriter compares the term of the ground lease to the term of the proposed loan and considers risk mitigants such as amortization to avoid repayment risk at the loan s maturity. Lenders often require that the term of the ground lease (including options) exceed the amortization period by a buffer period of years. 15

16 Extension Options An underwriter researches whether the borrower (the ground lessee) has options to extend the ground lease including the conditions and terms associated with such an extension. The impact of ground lease extension terms on the property s cash flow may impact the borrower s ability to refinance the loan at maturity. Changes in rental payments Since many ground leases terms are very long (50 99 years), they often provide for increases in rent during their term. The increases in rent may be based on a fixed amount, based on inflation (CPI or other indices), based on an updated appraised value of the land, or based on the cash flow generated by the improvements. An underwriter analyzes future changes in ground rent, and the impact of such changes on the property s ability to continue to service the proposed debt. Subordination An underwriter determines whether the ground lease will be subordinate or superior to the mortgage loan. In a subordinated ground lease, the lender s lien on the property will take precedence over the ground lessor s interest; after a mortgage loan foreclosure, the ground lease will be cancelled and the lender will own the land and improvements. In an unsubordinated ground lease, the mortgage lender will foreclose on the property subject to the ground lease, and would continue to make ground rent payments after the foreclosure. Other important considerations include the lender s right to receive notices of, and cure, ground lease defaults, use of insurance proceeds, financing of the ground lessor s interest and assumability of the ground lease. A ground lease may affect a property s value and its ability to generate cash flow to pay debt service on a mortgage loan. A capitalization rate ( Cap Rate ) used to value the property may be increased to reflect the added risk and complication of the ground lease. Ground rent can be incorporated into property cash flow analysis in several ways; including but not limited to: Treating ground rent as an operating expense, a common approach when the ground lease is subordinate to the mortgage loan; Treating ground rent as a senior lien on the property by excluding the ground rent from the calculation of Net Operating Income and Net Cash Flow and instead adding the ground rent to mortgage debt service when calculating Debt Service Coverage Ratio. Regardless of the terms of the ground lease itself, an underwriter may require a reserve for ground rent payments so any monetary defaults in a ground lease can be cured. Loan documents should give the lender, and therefore the servicer and investors, clear and specific notice and cure provisions relative to any unsubordinated ground lease. In addition, the CREFC 16

17 Model Representations and Warranties contain representations from the Loan Seller with respect to the key provisions of any ground lease. d. Underwritten Net Cash Flow Underwritten Net Cash Flow is Underwritten Net Operating Income less an allowance for ongoing capital expenses, including the cost of maintaining the property in its current condition and the cost of keeping existing tenants or attracting new tenants. Underwritten Net Cash Flow is an estimate of the cash available to make principal and interest payments on a proposed commercial mortgage, and is typically the numerator in the debt service coverage ratio. Leasing Costs While the expense of marketing to prospective tenants is treated as an ordinary operating expense, tenant improvements and leasing commissions are not considered part of Net Operating Income but are deducted to derive net cash flow. Tenant improvements are the costs for retrofitting a certain area of the building for a tenant in an office, industrial or retail property, and include such items as painting, carpeting, space partitioning, carpentry, light fixtures, restroom renovations, and other interior finishes. Tenant improvements are generally provided by the borrower as an inducement (or concession) to a prospective tenant to secure a lease. There is generally an inverse relationship between the cost of tenant improvement allowances provided to a tenant and the strength of the market (i.e., the greater the demand for space, the lower the tenant improvement allowance provided by the landlord). The borrower may also have to pay a leasing commission to the broker of the leasing transaction. An underwriter will typically calculate all costs estimated to lease vacant and re lease expiring space for office, retail and industrial properties based on the anticipated lease rollover schedule over the term of the loan. The cost of re leasing space adds risk to commercial mortgages secured by properties with anticipated significant lease expirations during the term of the loan. To mitigate that risk, an underwriter may require that the borrower contribute excess cash flow from the property or the borrower s own funds to a reserve fund for tenant improvements and leasing commissions at closing and/or monthly over the loan term. The greater of the normalized re tenanting expense amount or the required annual contribution is deducted from Underwritten Net Operating Income to calculate Underwritten Net Cash Flow. Leasing costs are included in Capital Expenses and generally disclosed in Annex A of the offering documentation for both historical performance and underwritten assumptions. 17

18 Replacement Reserves/Engineering Report Capital expenditures are costs incurred to maintain the collateral s physical condition and its competitiveness in the market. An underwriter engages an engineering firm to inspect the property and identify items requiring immediate repair (typically within 12 months) and items requiring attention over the loan term (the engineer s evaluation period is typically equal to the loan term plus two years). An underwriter typically requires that a portion of the loan proceeds be set aside in a reserve account at closing to cover the engineer s estimated cost of immediate repairs. The borrower is provided a time frame to complete these repairs (typically 6 to 12 months). The funds in the reserve account are then released to the borrower upon the lender s/servicer s satisfaction that the identified repairs have been completed. An underwriter also often requires the borrower to set aside up front loan proceeds or make monthly payments into a replacement reserve account in an amount at least equal to the needed reserves estimated by the engineer (average amount estimated over the engineer evaluation period). The borrower may draw upon these replacement reserves to complete capital repairs over the term of the loan. An underwriter will typically underwrite an estimate for ongoing capital expenditures based on the greater of the firm s minimum guideline for the property type in question or the engineer s estimate. Like leasing costs, this estimated annual amount is deducted from Underwritten Net Operating Income to calculate Underwritten Net Cash Flow. CREFC Model Representations and Warranties include a representation from the Loan Seller regarding the diligence performed with respect to the physical condition of the Mortgaged Property. Replacement Reserves underwritten in the calculation of Underwritten Net Cash Flow are generally disclosed in the offering documentation in Annex A. In addition, Annex A should include the amount of any upfront and ongoing reserve requirements for Leasing Costs, Replacement Reserves and any other required escrows. Environmental Related Expenses Due to federal regulations extending environmental liability to all owners in a property s chain of title, an environmental issue at the property will significantly limit the lender s ability to foreclose on the property in the event of default. Accordingly, the underwriter also engages a qualified environmental engineer to prepare a Phase I environmental assessment (as defined by the American Society of Testing Materials [ATSM]) of the property to identify areas of environmental concern. If issues of environmental concern are identified by the Phase I consultant, an underwriter may: 18

19 require additional investigation in the form of a Phase II assessment (also as defined by the ATSM; require that the issues identified be remediated prior to or subsequent to loan closing (the underwriter generally requires the establishment at closing of an environmental escrow to cover the costs of any post closing remediation); require that the borrower implement an operations and maintenance (O&M) program (in the case of properties with manageable asbestos or lead based paint); implement an environmental insurance policy; or withdraw or reduce the amount of the proposed financing. The cost of environmental remediation is typically reserved at closing; any ongoing monitoring or remediation cost is deducted from Underwritten Net Operating Income to derive Underwritten Net Cash Flow. The offering documentation should detail the amount of any upfront or ongoing reserves required for environmental remediation. In addition, CREFC Model Representations and Warranties include a representation from the Loan Seller regarding the diligence performed with respect to the environmental condition of the Mortgaged Property. f. Credit Metrics: Debt Service Coverage Ratio, Capitalization Rate, Debt Yield, and Loan to Value Ratio The Debt Service Coverage Ratio (DSCR) measures how much cash flow the property is generating to fund the proposed loan s debt service that is, the monthly payments of interest and principal. The DSCR is calculated by dividing the Underwritten Net Cash Flow by the annual contractual debt service. A DSCR of 1.0x implies that the property generates just enough cash flow to service the debt. A higher DSCR means the property is generating more cash than needed to cover debt service and therefore less risk of payment default, so the higher the DSCR the more Term Risk is mitigated. The appropriate Debt Service Coverage Ratio varies by property type and the expected volatility of cash flow. The Loan to Value Ratio (LTV) is computed by dividing the proposed loan balance by the value of the property. A lower LTV presents less risk to the proposed mortgage lender because in the event the value of the property declines it might still have sufficient collateral value to be able to repay the remaining balance of the loan. CMBS underwriters engage an appraiser to prepare a third party valuation of the property. These valuations are governed by the Uniform Standards of Professional Appraisal Practice (USPAP) and, if the lender is a bank, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). Appraisal methodology typically employs three approaches to value. The income approach is based on the property s net operating income and cash flow. The sales comparison 19

20 approach is based on the sale prices of comparable properties, and the cost approach is based on the amount required to replace the property (including the value of the land) adjusted for depreciation. In support of the valuation, the appraiser provides information relating to the attributes of the property and the market in which it competes, including comparable sales and rental rates. Depending on economic and market conditions, the appraiser generally places most weight on the income approach when reconciling the final value. An underwriter typically computes the LTV based on the final value concluded by the appraiser. LTV is both an indicator of the borrower s ability to repay the loan at maturity as well as an indicator of loss severity in the event of default. The Capitalization Rate (or Cap Rate) is the ratio between the Net Operating Income of a property and its value. Stabilized properties are often valued by dividing Net Operating Income by prevailing market Cap Rates; this valuation approach is used by appraisers as part of the income approach to value as discussed above. Debt yield is calculated by dividing the Underwritten Net Operating Income or Net Cash Flow by the proposed loan amount. Higher debt yields imply less risk. A property with a $1 million Underwritten Net Operating Income and a $10 million loan balance would have a debt yield of 10%. In this example, as long as property could sell at a capitalization rate of less than 10%, the proceeds generated from the sale of the property would be sufficient to repay the loan. When the debt yield is reported, it should be clear whether the calculation is based on Net Operating Income (NOI Debt Yield) or on Net Cash Flow (NCF Debt Yield). In CMBS lending, the issuer should disclose to investors which metrics were used to assess the creditworthiness of each commercial mortgage as well as how those metrics were calculated (i.e., the derivation of the numerator and denominator of each ratio). CREFC recommends disclosing Debt Yield and DSCR in Annex A using both Net Operating Income and Net Cash Flow calculations. IV. Borrower Analysis Commercial mortgages can be recourse or non recourse (typical of mortgages included in pools securing CMBS issuances). Recourse loans are considered less risky than non recourse loans. In a recourse loan, all of the borrower s assets and income (that is, in addition to the mortgaged property) may be relied upon by the lender to support the periodic loan payments of principal and interest as well as to repay any remaining principal balance upon refinance or maturity. Under a non recourse loan, the lender may only rely on the income produced by the property and the value of the property for periodic payments and principal balance repayment. Furthermore, CMBS borrowers are typically Single Purpose Entities ( SPEs ) with the property being the only asset of the entity. Therefore, there are no other assets or income sources to be 20

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